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The Hong Kong Monetary Authority (HKMA) has intervened after three months of weakness to maintain the HKD/USD peg under the Linked Exchange Rate System. While we have long argued  that the HKMA has the resources to sustain the peg over the medium term, doubts and confusion about the peg continue to emerge as capital drains from Hong Kong.
The Hong Kong-US dollar exchange rate has remained on the weak side of the ‘Convertibility Undertaking’ of 7.85 since May, triggering automatic intervention by the HKMA to uphold the peg. As a result, Hong Kong’s foreign exchange reserves have fallen and interest rates in Hong Kong have recently started to rise.
Aggregate balance, not FX reserves
Some market participants have confused Hong Kong’s aggregate balance – which fell from over HKD 400 billion last year to only HKD 165 billion in July (see Exhibit 1) – with its foreign exchange (FX) reserves. They see the reserves soon falling to zero and are concerned the peg might break down.
Hong Kong’s aggregate balance is its pool of interbank liquidity, however, not its currency reserves. Some hedge funds shorted the Hong Kong dollar in 2018 based on the incorrect belief that the reserves were depleting when they in fact were looking at the aggregate balance. They suffered big losses as the Hong Kong dollar peg withstood their speculative attack.
Hong Kong’s FX reserves are still huge, standing at USD 447.3 billion in June, two times the size of Hong Kong’s monetary base, M0.
Where are the FX reserves?
In a central bank’s accounts, including those of the HKMA, FX reserves are recorded in the capital account of the balance of payments, not on the central bank’s balance sheet.
Hong Kong’s FX reserves include assets from the Exchange Fund and the Land Fund. The former is managed in two main portfolios – the Backing Portfolio and the Investment Portfolio – and two smaller portfolios, the Long-term Growth Portfolio and the Strategic Portfolio (see Exhibit 2).
- The Backing Portfolio consists of stable, high-quality, US dollar-denominated assets to ensure the monetary base (M0) is fully backed at a rate of USD1 to HKD 7.8. The minimum-assets-under-management-to-M0 ratio is 105%. Below this level, the government will inject assets to safeguard the minimum ratio. If the ratio reaches 112.5% or higher, the government will transfer assets out of the portfolio to maintain the ratio cap.
- The Investment Portfolio is invested in global secondary markets in line with the government’s investment guidelines.
- The Long-term Growth Portfolio has been invested in private equity and property since 2009 and the Strategic Portfolio has invested in the Hong Kong Stock Exchange since 2007.
- The Land Fund was created in 1985 by the Sino-British Joint Declaration to receive revenues from government land sales.
The HKMA also manages the government’s fiscal reserves in the investment portfolio under the Exchange Fund. But these are two separate and distinct entities in the government’s records.
Aggregate balance and the HKD peg
The aggregate balance is related to the Hong Kong dollar peg through the interest-rate channel. When Hong Kong has a large aggregate balance, the banking system is flooded with liquidity. If Hong Kong dollars flow out, the aggregate balance falls, as is happening now. Less interbank liquidity means local banks have to raise interest rates (thus following the current US rate trend) when they bid for liquidity in a smaller pool.
Higher Hong Kong rates should halt capital outflows, or even attract inflows, thus stopping or reversing the downward pressure on the Hong Kong dollar. This is the automatic adjustment mechanism under LERS. The HKMA only acts passively, when required by capital flow pressures.
The implication is that with Hong Kong interest rates rising as the aggregate balance falls, Hong Kong’s asset markets will face tough interest-rate headwinds in the coming months.
Support from robust fundamentals
Despite the capital outflows, economic fundamentals are sustaining the Hong Kong dollar peg.
According to the International Monetary Fund’s guidelines for foreign exchange reserve adequacy, a country’s currency reserves should be
- At least enough to cover three months of imports
- Equate to 20% of broad money supply
- Sufficient to cover 100% of short-term external debt.
As of this June, Hong Kong’s FX reserves were enough to cover almost nine months of imports, 45% of broad money supply and 155% of short-term foreign debt.
So while the aggregate balance is falling, it will not break the Hong Kong dollar peg.
 For earlier reports, see Chi on China: The Hong Kong Dollar Peg is Different – Long Live the Peg”, 28 May 2019, and “Chi Time: The Ultimate Question of the Hong Kong Dollar Peg”, 23 August 2019. For the most recent report, see “Chi Time: A Fireside Chat about the Hong Kong Dollar – It Hits 7.85, again”, 13 May 2022.